Friday, December 11, 2009

I Challenge Krugman on His Home Court

There are a lot of good things you can say about international trade. But it does not, repeat not, do anything to alleviate a shortage of overall demand. Yes, if you liberalize trade countries will export more. But they will also import more. If you’re worried about C+I+G+X-M, it’s a wash, because X and M rise equally.

I said in the comments (still awaiting moderation):

On most matters I have the intrepidity to challenge Paul Krugman, but even I hesitate to question him when it comes to a Keynesian analysis of international trade. Nonetheless I must throw caution to the winds and ask:

Dr. Krugman, are you saying that if all countries sealed off their borders completely, world Y (real output) would remain unchanged?

--Bob Murphy

UPDATE: I used a reductio ad absurdum in my comment, but somebody else (Scott Wentland) really hit the nail on the head:

Imports are subtracted from exports…but they are included in consumption. The imports are a wash, but exports do add to GDP…

I have already submitted a Mises Daily on this issue, so I can't include this point. It's consistent with what I was saying, but I think Wentland boiled down my entire article to two sentences.

The standard GDP equation measures C as the total amount of money spent on consumption goods by people within the country's borders. That's why you need to include the (X-M) component in the first place, to adjust the C and I figures for Americans who spend on foreign goods, and for foreigners who spend on American goods.

So let's say there initially are 1000 unemployed Americans, and then a new trade deal "creates jobs" so that they can ship $50 million worth of novels to South Asia. Americans collectively then import $50 million of electronics goods from South Asia. That influx of electronic goods into the US is counted as (a) an extra $50 million in consumption spending by US consumers and (b) $50 million worth of imports used to offset the $50 million increase in exports.

Thus, GDP goes up by $50 million, and the "new demand" from Asia allows 1000 previously unemployed people to get jobs paying $50,000 each. If you don't understand how this is possible, imagine the newly employed workers spend their $50 million on local merchants, who then use the extra income entirely to buy $50 million more in electronics goods from South Asia. There is no reason for anyone in the US to reduce his original consumption spending, and the people who are buying more Asian goods have exactly that much more income to finance it. The "trick" is that you've got 1000 people working who previously weren't doing anything.

Of course in reality, things would be a lot messier. I'm just putting some meat on Wentland's point, which shows Krugman's argument is simply wrong.

Strange how sometimes the comments never make it though, eh? Another tactic Krugman (or his moderator) uses is to hold off your comment, pending moderation, for so long that by the time it appears, many new blog entries have been made.

I'm actually not accusing Krugman of that trick, I was just explaining why you wouldn't see my comment if you went to his post.

DeLong certainly gongs people for the smallest of infractions, but Krugman (or whoever) has let through my stuff in the past few weeks. I don't know if they purposely hold it up, but he has so many readers I can't claim that I'm sure he is doing so.

If you get an answer, it will surely be similar to the one he gave Scott Sumner in a different context: "I have never said such a thing." There's a world of difference between saying that X and M both rise and saying that Y does not change. You know that of course, which makes me wonder just what you're getting at?

Bob Murphy: Krugman explicitly said that opening trade up would not lead to an increase in aggregate demand.

No, he said it would not alleviate a shortage of overall demand. Potential GDP increases. Actual GDP increases. The gap remains. Workers are laid off in the import-substitution industries and employment increases in the export industries. Krugman isn’t saying something new here. He’s saying what he said years ago about NAFTA: increased trade doesn’t destroy jobs and it doesn’t create jobs either. It allocates resources more efficently, that is all.

He may be wrong. But you haven’t made the case that he is and your update really doesn’t help. Your example ignores the fact that American producers of electronic goods lose out to foreign competition and shed workers.

DD5: Are we shocked that Krugman does not understand the benefits of the division of labor?

It would certainly be shocking if it were true. As Bob Murphy acknowledged at the outset, trade is very much Krugman’s area of expertise. Of course he can make mistakes like anyone else. If the claim was that he went wrong in some tricky algebra I wouldn’t be startled at all; he works hard at algebra but he doesn’t pretend to like it. The blunder here alleged is not of that sort, it’s quite basic.

(1) Do you mind if I quote your last comment (or a portion of it) in my Mises Daily article? I want to put it in a footnote for the purists because it's a very good objection to my take on Krugman. I'm not going to respond to it there (since I made my much more basic point in the article already), but I do want to give your POV a hearing since it's a very subtle issue.

(2) You're right, Krugman might have in mind what you are talking about. However, my main point (which I make more clearly in the submitted article than I did in this blog post) is that he is relying on a broader Keynesian theory to prove it, whereas in his post he is making it sound as if it flows from the identity. Do you agree that the X-M thing per se is a confusion?

You said that I ignored the possibility of American producers of electronics goods losing their jobs because of the new imports, but actually I didn't. I said, "There is no reason for anyone in the US to reduce his original consumption spending, and the people who are buying more Asian goods have exactly that much more income to finance it."

So I didn't spell it out, but I'm saying it is certainly possible that the numbers work out such that no American producer loses any business at all. In practice that won't be true, of course, and that's what I meant about things being messier in the real world.

If you wanted to make it really ridiculous, suppose that the newly hired 1000 workers spend their entire paychecks importing the new goods from Asia, while the rest of the US is completely unaffected.

So in closing, I agree that Krugman probably had a model result in mind, in which his statements were correct. (In particular, if we were originally at full employment, then obviously a trade agreement could only rearrange workers into higher-paying jobs on average. It couldn't create jobs on net.) But his post made it sound as if the X-M thing was decisive, when--as that other commenter pointed out more succinctly than I did--this is totally wrong. On the first pass of analysis, rising imports and exports also raise C and/or I, meaning Y goes up. Only if you supplement Krugman's point with an argument about why other jobs should be exactly counterbalanced will his result go through.

If you want to argue that Krugman's claim is not a knife edge but is in fact the general outcome in a standard Keynesian model where we're stuck below full output, OK please try to help me see it. But I think even in that case, Krugman's quick post was still very misleading at best.

KD scratch the last part there--I got sucked into worrying about the absolute level of Y, when your point is that Y per se doesn't matter, but the gap between Y and Y[full employment].

But why do I keep going back to Y? Because that's what Krugman brought up to "prove" his point. Under your (plausible) interpretation of what he's saying, talking about Y is totally irrelevant, and so talking about X and M is totally irrelevant, right?

In other words, how does saying, "Yes X goes up by so does M" have anything to do with the statement, "So the gap between Y and potential Y remains the same, even if Y goes up"?

Apologies for the late response, I’m in a different time zone. Of course you can quote me.

“Do you agree that the X-M thing per se is a confusion?” Not really. He could have made himself clearer, but his main point – that trade liberalisation is not a job-creation measure – comes through clearly enough. I don’t agree that “talking about Y is totally irrelevant and so talking about X and M is totally irrelevant.” The context is that we want a policy which increases employment. To argue that trade liberalisation is such a policy, we would need to show that jobs created in the export sector exceed jobs lost in import-substitution. The reference to X and M is just shorthand for that.

And I don’t altogether agree that he is relying on a specifically Keynesian theory. Think of a model with purely classical unemployment caused by pegging real wages above the full-employment level. A liberalisation of trade will increase both X and M but it’s hard to see how it does much to increase Y or reduce unemployment. It might even increase unemployment, by reducing the market-clearing real wage. I suppose, on net, Y should be up thanks to the gains from trade, but if I was a student at Princeton I’d want to study the model for a while before arguing that with Krugman. Since I’m not, I’ll just guess that the impact on Y is indeterminate. Potential GDP must be a bit higher since trade liberalisation is akin to technical progress. Finally, I agree that it’s possible that there might be no losers from trade liberalisation, but that’s a special case and a very unlikely one.

OK I will definitely reproduce your POV and send the interested readers here. BTW are you an official economist (for identification purposes)? If not that's fine, just wondering how to describe you.

As far as our dispute, I think you are getting backed into a corner. At this point, I think the best you can argue is that the WaPo didn't understand why they were right, and that Krugman is right as far as first-order effects but not overall. (I'm not even conceding these points, just saying I think that's the best you've got at this point.)

I have to be quick so here goes:

* You say that it's possible there could be no losers from trade (and hence I'm right that it creates jobs), but that's not the general case. Right, but the general case is that there are more winners than losers. So doesn't that mean in general, trade creates jobs when you start with unemployment?

* Take your e.g. of a wage floor: Wouldn't a technological innovation then reduce unemployment, by raising more people's productitivities above the floor?

As to using first names, I think there is a blogosphere convention of informality, which I like and follow unless people object. As they say at Crooked Timber, a good comment thread is like a lively argument in a pub. I’m not an official economist, so you can use whatever description is usual for laymen who blunder into the crossfire. Nick Rowe did a survey of his readers last June. I described myself as follows: Irish, live in Dublin. Retired, do a bit of freelance work when the opportunity arises. Worked in banking and corporate treasury 1971-2001, with a break in the 1980s when I went back to college full-time. Masters in economics from UCD.

From that you will gather that backing me into a corner wouldn’t be much of an achievement but, if you really want to go after Krugman on this issue, I hope you’re aware that he has been pushing this argument for decades. You certainly won’t find him unprepared. In a 1993 AER paper, “What Do Undergrads Need to Know About Trade?” (reprinted in Pop Internationalism) he wrote:

“...the level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with microeconomic policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency, not in terms of phony numbers about jobs created or lost.”

On your two quick points: (1) When I say that trade generally creates more winners than losers, I’m really just repeating the uncontroversial point that liberalisation is Pareto-improving. That doesn’t mean that it creates more jobs than it destroys. People may benefit as employers and consumers while losing out as workers. (2) A technological innovation can raise the productivity of unskilled workers and thereby put skilled workers out of jobs; similarly with trade liberalisation, especially between rich and poor countries. That’s not a good reason for American workers to oppose free trade; Krugman has devoted a lot of his time to explaining why they are likely to be net gainers from trade. But the gains don’t usually take the form of increased employment.

“...the level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with microeconomic policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency, not in terms of phony numbers about jobs created or lost.”

Kevin, I have no problem with any of the above (except that I am not a Keynesian and so think focusing on Aggregate Demand is very dangerous).

In fact I gave a talk at the Mises Institute one time on the "leading myths about trade" or something like that, and one myth was "trade destroys jobs" while the next myth I discussed was "trade creates jobs."

So believe me, I understand what you are saying here, in general.

But in this specific instance, my point is that increasing trade will boost aggregate demand, and hence it will reduce unemployment. The reason it boosts AD is that the new trading opportunity makes people's incomes go up, and so their consumption and investment spending rises.

Moreover, what really irked me about Krugman's post was him pointing to the X and M, while ignoring the C and I. So no matter how you slice it, I think he was just plain wrong. If we do a careful, full general equilibrium analysis, I think he's wrong (perhaps because of a second-order effect), and if we do a partial equilibrium, let's-just-look-at-the-impact-on-the-identity approach, then he's wrong too.

Mr. Murphy, I just wanted to say that I am a big fan. A Bob Murphy groupie I guess. Your talks that get posted on the Mises Media are invaluable! Thanks for directing to your blog in the recent Mises Daily article on Krugman. Very helpful in understanding the trade equation!